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What is Financing Process?

In 1963, MM added corporate taxes to their model. With corporate taxes considered, a firm’s stock price was shown to be directly related to its use of debt financing – higher the percentage of debt financing, the higher the stock price. Under the MM with tax theory, firms should use virtually 100% debt financing. Our tutors at transtutors.com are highly qualified and undergo months of training before providing Homework Help and Assignment Help.

The reason for this result is the corporate tax structure – returns to stockholders come from after-tax earnings, but returns to creditors are paid before tax. The effect of this tax treatment is that more of a company’s operating income is left for investors when more debt financing is used. Even more such useful points are covered in simple way of learning through which you can have a good command on your stream in Accounting Homework and Assignment help at transtutors.com.

Modigliani and Miller basic propositions with corporate taxes are as follows:

Proposition I

The total market value fo a leveraged firm is equal to (1) the value of an unleveraged firm in the same risk class plus (2) the gain from leverage, which is the value of tax savings due to debt financing and which equals the corporate tax rate times the amount debt the firm uses.

VL = VU + TD

With zero debt the value of the unleveraged firm is equal to the value of its equity

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Proposition II

The cost of equity of a leveraged firm is equal to (1) the cost of equity of an unleveraged firm in the same risk class plus (2) a risk premium, whose size depends on the differential between the costs of equity and debt to an unleveraged firm, the amount of financial leverage and the corporate tax rate.

ke,L= ke,U+ Risk Premium = ke,U+ (ke,U+ kd) (1 – T)(D/E)

This means that as the firm’s use of debt increases, its cost of equity also rises but at a slower rate now because of the effect of (1-T) which is less than 1.

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